What is the 3.8% Net Investment Income Tax (NIIT)?

What is the 3.8% Net Investment Income Tax (NIIT)?
The Net Investment Income Tax was created as part of the Affordable Care Act in 2013 to raise revenue for Medicare. That’s why it’s also called the Unearned Income Medicare Contribution Surtax (UIMCS). The Net Investment Income Tax is enforced by Section 1411 of the Internal Revenue Code. The 3.8% Net Investment Income Tax applies on the lesser of the taxpayer’s net investment income or the amount that exceeds the taxpayer’s modified adjusted gross income (MAGI). The Net Investment Income Tax “applies at a rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts.”
https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax

“What individuals are subject to the Net Investment Income Tax? 
Individuals will pay the 3.8% tax “if they have net investment income and also have modified adjusted gross income (MAGI) over the following thresholds:”
$250,000 of MAGI for married filing jointly,
$125,000 of MAGI for married filing separately,
$200,000 of MAGI for single,
$200,000 of MAGI for head of household (with qualifying person),
$250,000 of MAGI for qualifying widow(er) with dependent child.

With the current law, the thresholds are not indexed for inflation.
https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax

What is modified adjusted gross income?
For many taxpayers, their modified adjusted gross income is the same as their adjusted gross income. Modified adjusted gross income is adjusted gross income (Form 1040, Line 11) plus certain deductions and exclusions. This is directly from the TurboTax website. “To calculate your modified adjusted gross income, take your AGI and add back certain deductions. Many of these deductions are rare, so it's possible your AGI and MAGI can be identical.

According to the IRS, your MAGI is your AGI with the addition of the following deductions, if applicable:
● Student loan interest 
● One-half of self-employment tax 
● Qualified tuition expenses 
● Tuition and fees deduction 
● Passive loss or passive income 
● IRA contributions 
● Non-taxable social security payments 
● The exclusion for income from U.S. savings bonds 
● Foreign earned income exclusion 
● Foreign housing exclusion or deduction 
● The exclusion under 137 for adoption expenses 
● Rental losses 
● Any overall loss from a publicly traded partnership”
https://turbotax.intuit.com/tax-tips/irs-tax-return/what-is-the-difference-between-agi-and-magi-on-your-taxes/L7kHckNS3

It’s important to know your modified adjusted gross income because it helps you determine if you are eligible for certain tax deductions and credits, can you contribute directly to a Roth IRA, can you deduct the contribution to a Traditional IRA, et cetera.

Different modified adjusted gross incomes relate to different topics.
Our modified adjusted gross incomes are different depending on what we are relating it to. For example, we use this worksheet on the IRS website to figure out our modified adjusted gross income for traditional IRA purposes.

Adjusted gross income (AGI)
+ student loan interest deduction
+ tuition and fees deduction
+ foreign earned income exclusion and/or housing exclusion
+ foreign housing deduction + excludable savings bond interest
+ excluded employer-provided adoption benefits
————————
= Modified AGI for traditional IRA purposes.
https://www.irs.gov/publications/p590a#en_US_2019_publink100025076

What is the modified adjusted gross income for Net Investment Income Tax purposes?
On Form 8906, Page 19 of 20, MAGI Worksheet:
Adjusted Gross Income
+ Foreign Earned Income Exclusion
+ Adjustments for Certain Controlled Foreign Corporations and Certain Passive Foreign Investment Companies
————————
= Modified Adjusted Gross Income (MAGI) relates to the 3.8% Net Investment Income Tax.
https://www.irs.gov/pub/irs-pdf/i8960.pdf

On Form 8906, Page 18 of 20. “Modified Adjusted Gross Income (MAGI). If you didn’t exclude any amounts from your gross income under section 911 and you don’t own a Controlled Foreign Corporation (CFC) or Passive Foreign Investment Company (PFIC), your MAGI is your AGI as reported on Form 1040 or 1040-SR. If you exclude amounts under section 911 or own certain CFCs or PFICs, your MAGI is your AGI as modified by certain rules described in Regulations section 1.1411-10(e)(1).
https://www.irs.gov/pub/irs-pdf/i8960.pdf

Here is a direct quote from H&R Block, “For Net Investment Income Tax (NIIT) and IRS Form 8960, your Modified Adjusted Gross Income (MAGI) is your Adjusted Gross Income (AGI) generally increased by the amount of foreign earned income you excluded. Additional adjustments to your AGI may be needed if you own, directly or indirectly, stock in a Controlled Foreign Corporation or Passive Foreign Investment Company.”
https://www.hrblock.com/tax-center/irs/forms/tax-form-8960

What is included in the Net Investment Income Tax?
The word “net” means investment income minus investment expenses. This equals net investment income. 

Investment incomes include, but not limited to: 
● Capital gains
● Distributions from non-qualified annuities
● Dividends
● Income from passive activities
● Interest
● Rental incomes
● Royalties

“The investment expenses include, but not limited to: 
● Investment interest expense
● Investment advisory and brokerage fees
● Expenses related to rental and royalty income
● Tax preparation fees
● Fiduciary expenses (in the case of an estate or trust) and state and local income taxes.”
https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax

“What are some common types of income that are not Net Investment Income?
● Wages
● Unemployment compensation
● Operating income from a non-passive business
● Social Security Benefits
● Alimony
● Tax-exempt interest
● Self-employment income
● Distributions from certain Qualified Plans” (401(k) Plans, 403(b) Plans, 457(b) Plans)
https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax

What kinds of net gains are included in Net Investment Income?
Some examples are:
● “Gains from the sale of stocks, bonds, and mutual funds.
● Capital gain distributions from mutual funds.
● Gain from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence).
● Gains from the sale of interests in partnerships and S corporations (to the extent the partner or shareholder was a passive owner).”

A common question I get is does the 3.8% Net Investment Income Tax apply to the sale of stock? Yes, because it’s “gains from the sale of stocks.”
https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax

Examples of the Net Investment Income Tax.
A married couple filing jointly earned $230,000 in wages. They also have $40,000 in net investment income from selling their stock. Their modified adjusted gross income is $270,000 ($230,000 plus $40,000). $270,000 minus $250,000 threshold limit for married filing jointly equal $20,000. The net investment income is $40,000.  The net investment income tax is based on the lesser of $20,000 or $40,000. Thus, the couple will owe a Net Investment Income Tax of $760 ($20,000 X 3.8%).

A single filer earned $180,000 in wages and received $70,000 from passive income in a business. The modified adjusted gross income is $250,000 ($180,000 plus $70,000). $250,000 minus $200,000 threshold limit for single filer equal $50,000. The net investment income is $70,000. The Net Investment Income Tax is based on the lesser of $50,000 or $70,000. Thus, the single filer will owe Net Investment Income Tax of $1,900 ($50,000 X 3.8%).

A single filer with $240,000 of adjusted gross income and $20,000 in net investment income from dividends and realized capital gains in her brokerage account. $240,000 AGI + $20,000 Net Investment Income - $200,000 threshold = $60,000. The net investment income of $20,000 is less than excess of modified adjusted gross income threshold of $60,000. $20,000 X 3.8% = $760.

Luna, who filed as a single filer, worked at Best Wealth Management Company in San Francisco and makes $180,000 a year. Is she subject to the 3.8% Net Investment Income Tax? If so, what is the tax implication? No, because her modified adjusted gross income is less than the $200,000 threshold limit and she does not have net investment income. 

Luna, who filed as married filing separately, works at Top Financial Planning Corporation and makes $180,000 a year, and realized $100,000 in net long-term capital gain. Is she subject to the 3.8% Net Investment Income Tax? If so, what is the tax implication? Yes, she is subject to the 3.8% Net Investment Income Tax. $180,000 (wage) + $100,000 (capital gain) - $125,000 (married filing separately) = $155,000. The net investment income of $100,000 is less than the excess of the modified adjusted gross income threshold of $155,000. $100,000 X 3.8% = $3,800. What I have seen from this question is that a lot of students and test-takers make the mistake of using the single filer limit of $200,000 instead of the married filing separately limit of $125,000. Remember to read the questions slowly and ask yourself why the multiple-choice answers the way they are. 

Let’s look at two more examples:
Who will have the less 3.8% Net Investment Income Tax liability? 
Luna, who filed as a single filer, worked at Elite Fiduciary Financial Advisors, made $220,000 a year, and realized $240,000 of long-term capital gain. 
Lucky, who filed as a single filer, worked at Elite Fiduciary Financial Advisors, made $240,000 a year, and realized $220,000 of long-term capital gain. Let’s do the math.

Luna: $220,000 (wage) + $240,000 (capital gain) - $200,000 (single filer) = $260,000. Luna’s net investment income of $240,000 is less than her excess modified adjusted gross income threshold of $260,000. $240,000 X 3.8% = $9,120.

Lucky: $240,000 (wage) + $220,000 (capital gain) - $200,000 (single filer) = $260,000. Lucky’s net investment income of $220,000 is less than his excess modified adjusted gross income threshold of $260,000. $220,000 X 3.8% = $8,360. Lucky will have the less 3.8% Net Investment Income Tax liability.

Here is an example from the IRS website. A married couple filing jointly sold their personal residence and realized a gain of $600,000. $600,000 minus the $500,000 Section 121 exclusion equal $100,000. They also have $125,000 of net gains from the sale of stock. Their total net investment income is $225,000. Their modified adjusted gross income is $300,000. The modified adjusted gross income threshold is $250,000 for married filing jointly. Thus, they are $50,000 over the married filing jointly threshold ($300,000 - $250,000). They are subject to the Net Investment Income Tax on the lesser of $225,000 of the net investment income or $50,000 (the couple's modified adjusted gross income exceeds the $250,000 married filing jointly threshold). They owe Net Investment Income Tax of $1,900 ($50,000 X 3.8%). Remember, the 3.8% Net Investment Income Tax applies on the lesser of the taxpayer’s net investment income or the amount that exceeds the taxpayer’s modified adjusted gross income (MAGI).
https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax

Section 121 exclusion.
The section 121 exclusion is excluding the gain of a primary residence of $250,000 for a single filer and $500,000 for a married filing jointly filer. Either spouse can meet the ownership test, but both spouses must meet the use test. The home must be owned and used as a primary residence for a total of 2 years out of the 5 years from the date of sale. The 2 years do not have to be consecutive years. The taxpayers have not claimed the exclusion in the last two years which means the taxpayers can use the section 121 exclusion every two years. The taxpayers are also entitled to a partial exclusion if they don’t meet the full timeframe for the ownership test and the use test. This is a high overview of section 121 exclusion and you can learn more on the IRS website and talk to a qualified professional. 
https://www.irs.gov/taxtopics/tc701

Are the following subject to the 3.8% Net Investment Income Tax?
● Incomes from non-qualified annuities? Yes, the gains are subject to the Net Investment Income Tax. Although non-qualified annuities are subject to the 3.8% Net Investment Income Tax, it does not mean there is a tax liability because it depends on the taxpayer’s modified adjusted gross income and net investment income.
● IRC Section 1031 exchange (real estate)? No, it’s not subject to the Net Investment Income Tax.
● IRC Section 1035 exchange (life insurance, long-term care insurance, and annuities)? No, it’s not subject to the Net Investment Income Tax.
● Tax-qualified retirement accounts (401(k) plans, 403(b) plans, 457(b) plans, Traditional IRA, Roth IRA, profit-sharing plans, pensions, annuities inside IRAs, et cetera)? No, it’s not subject to Net Investment Income Tax.
● The bargain element from exercising incentive stock options (ISOs)? If the investor exercises the incentive stock options and holds the employer stock, the bargain element is not subject to the 3.8% Net Investment Income Tax. When the investor sells the employer stock in the future, the investor could be subject to the 3.8% Net Investment Income Tax because it depends on the investor’s modified adjusted gross income and net investment income. If the investor exercises the incentive stock options and sells the employer stock in the same calendar year, the bargain element is considered compensation income and it’s taxed at ordinary income tax rates. Thus, the investor could be subject to the 3.8% Net Investment Income Tax because it depends on the investor’s modified adjusted gross income and net investment income.

What about the standard deduction or the itemized deduction?
You calculate your adjusted gross income which is on Form 1040, line 11, then you subtract the standard deduction of $12,400 for a single filer or $24,800 for married filing jointly filer for 2020 or the itemized deductions which is on Form 1040, line 12, to equal your taxable income which is on Form 1040, line 15. 

Adjusted Gross Income - Standard Deduction or Itemized Deduction = Taxable Income.

You take your adjusted gross income (Form 1040, Line 11) then add back certain deductions and exclusions to get your modified adjusted gross income. Thus, the standard deduction or the itemized deduction do not play a role in calculating your modified adjusted gross income. When you hear people talk about “the line,” they are referring to your adjusted gross income (Form 1040, line 11). Above the line deduction can lower your adjusted gross income and below the line, such as the standard deduction or the itemized deduction, cannot lower your adjusted gross income. I like above-the-line deductions because you can do a lot of creative planning to qualify for certain deductions and credits. 

What else do we need to know relates to the 3.8% Net Investment Income Tax?
● The Net Investment Income Tax is calculated and reported on IRS Form 8690 which is filed with Form 1040 U.S. Individual Income Tax Return.
● Capital gains taxes are progressive, similar to ordinary income taxes.
● The 3.8% Net Investment Income Tax is in addition to the long-term capital gains tax rates. If our long-term capital gain tax rate is 20% and we are subject to the 3.8% Net Investment Income Tax. Our total tax is 23.8%.
● The 3.8% Net Investment Income Tax and the 0.9% Medicare Surtax on Wages and Self-Employment Income are different. 0.9% Medicare Tax is on earned income (examples are wages and self-employment income) when taxpayers reached above certain thresholds. Here is a direct quote from the IRS website. “The Net Investment Income Tax is separate from the new Additional Medicare Tax, which also went into effect on January 1, 2013. You may be subject to both taxes, but not on the same type of income. The 0.9 percent Additional Medicare Tax applies to individuals’ wages, compensation, and self-employment income over certain thresholds, but it does not apply to income items included in Net Investment Income.”
● Although distributions from retirement accounts, such as 401(k) Plans, 403(b) Plans, 457(b) Plans, SEP IRA, et cetera, are considered ordinary income and not investment income, the ordinary income will increase the investor’s modified adjusted gross income and they could be subject to the 3.8% Net Investment Income Tax if their modified adjusted gross income is above the statutory threshold and they have net investment income. 
● The 3.8% Net Investment Income Tax does not apply to nonresident aliens and certain charitable trusts.
● Does the 3.8% NIIT apply when you exercise ISOs and sell them in the same calendar year? No.
https://www.irs.gov/individuals/net-investment-income-tax

How can we avoid the 3.8% Net Investment Income Tax?
● Try to keep our modified adjusted gross income below the statutory threshold so we are not subject to the 3.8% Net Investment Income Tax.
● Avoid increasing taxable income when we don’t have to, such as doing a Roth conversion. When we do a Roth conversion, all the earnings and tax-deductible portion of the Traditional IRA increase our income. I say the tax-deductible portion of the Traditional IRA because we don’t get tax on the amount we did not deduct. All earnings are taxable regardless if the earnings come from deductible and nondeductible contributions.
● It’s net investment income and not gross investment income. If we can increase investment expenses to lower our net income, that is another way to avoid the Net Investment Income Tax. Examples of expenses are rental property expenses, investment trade fees, and state and local taxes.
● Prepaid deductible investment expenses such as state and local income taxes on investment income, investment interest expenses, and property taxes on investment properties.
● Contribute to accounts that can reduce our income such as, 401(k) plan, 403(b) plan, 457(b) plan, SEP IRA, deductible Traditional IRA, TSP, health savings account, et cetera.  
● Installment sales. If applicable, spread the gains from a sale of a business or investment property over multiple years instead of realizing all the gains in one year.
● If we are charitably inclined, we can donate appreciated assets to qualified charities instead of realizing the appreciated assets, pay the taxes, then donate the money. For clients that are age 70 1/2 or older and are charitably inclined, qualified charitable distributions (QCDs) are a great option.
● Sell investments at a loss to offset investment gains.
● Defer capital gain, such as selling the investment in the future instead of selling it now. 
● Use Section 1031 like-kind exchange which is selling an investment property and using that money to buy another investment property.
● Use Section 1035 exchange to defer the gains. An investor can replace:
—a life insurance policy with another life insurance policy, 
—a life insurance policy with an annuity, 
—a life insurance policy with a qualified long-term care policy,
—an annuity with an annuity, 
—an annuity with a qualified long-term care policy,
—and a qualified long-term care policy to another qualified long-term care policy.
—You cannot do a 1035 exchange from an annuity to a life insurance policy because the IRS wants to tax the gains on the annuity. Generally, life insurance death benefit is income tax-free and not estate income tax-free. If you are able to fund an annuity then use that money to transfer it to the life insurance policy, the death benefit could be income tax-free. The IRS doesn’t like that. That’s why you cannot do a 1035 exchange from an annuity to a life insurance policy.

Summary
Please note that this material is for educational use only. Tax laws are complex, there are exceptions to the rules, and it’s constantly changing. I am giving you a high-level overview and did not go into all the little details or we will be here for days. You should talk to a qualified professional before making any financial decisions. I love the IRS website because it gives me so much information I can use to enhance my family and clients’ finances. If you know how to look for the information and truly understand the content, you will have the same love for the IRS website as me. Thank you for watching. Until next time. This is Tan, your trusted advisor.

Resources:
Net Investment Income Tax - https://www.irs.gov/taxtopics/tc559
Form 8960 - https://www.irs.gov/pub/irs-pdf/f8960.pdf