If you’re a dentist, doctor, or other entrepreneur who has looked closely at your tax return this year, you probably noticed a new form 8960 hitting you with a new “Net Investment Income” tax, or simply NII for short. This blog gives a quick overview of the tax, and provides a few ideas – and warnings – about how to plan for the tax appropriately.
What is the NII?
The NII tax is an entirely new tax, meaning that it’s in addition to all other taxes you already pay, such as payroll tax, self-employment tax, alternative minimum tax, capital gains tax and, of course, regular tax (the last two of course also having been increased in 2013 through the addition of higher tax brackets). The NII tax is a 3.8% tax on the lesser of net investment income and income over $250,0001, and that limit is not adjusted for inflation, so as the value of the dollar decreases each year, more and more people will get caught by the tax each year.
To give a quick example, say that you earned $500,000 of adjusted gross income2 this year which puts you in the highest tax bracket. Then let’s say you trade stocks that pay dividends, and you have ordinary dividends on your tax return. You would end up having to pay regular tax at 39.6% plus the 3.8% net investment income tax on top of that, putting your Federal rate at a whopping 43.4%. Considering that your itemized deductions and exemptions are getting phased out, and state taxes that makes about half your money going to the government.
The NII tax was created to help offset the cost of the new Affordable Care Act enacted in 2013. The Obama administration wanted to finally catch those evil rich people who aren’t paying their fair share, such as the Warren Buffets and Mitt Romneys of the world whose income comes mostly from passive activities such as interest, dividends, annuities, royalties, rents, and capital gains, and therefore avoid paying tax at ordinary rates. Congress also released at the same time an additional 0.9% Medicare payroll tax that hits taxpayers on their W-2 at the same threshold as the NII. The Medicare tax is set at 2.9% on all W-2 income, and the additional 0.9% brings it up to 3.8% which is why they picked 3.8% for the NII. Whether your income is active or passive, Congress has your number.
Avoiding the NII Tax on Self-Charged Rental Income
Luckily there is some escape. While Congress did cast the net fairly wide on the NII it did leave in some exclusions from the tax, most of which were on purpose. Examples include:
- Social security benefits
- Tax-exempt interest
- Certain retirement distributions
- Certain self-charged interest and rental income treated as non-passive
The first four points are fairly obvious, so let’s focus on the last point: self-charged rental income.
Many dentists, doctors, and entrepreneurs own the building in which their practice or business operates, and the practice pays rent monthly to cover the mortgage, utilities, and other costs. Typically the practice is owned in an operating business, and the real estate is owned in a separate business (hopefully anything but a C or S corporation) which collects the rent, holds the title, and any debt associated with the building. By default this rental income will show up on your form 8960 because it is rental real estate income. Fortunately when an individual rents property to an activity in which he or she materially participates, that rental income is deemed to be derived in the ordinary course of a trade or business3 and is not subject to the NII tax. Simply back it out on the next line down on form 8960 and voila no NII.
Although you could take a five-week course on the definition of “material participation” generally if you work at least 500 hours at your business during the year you’ll be safe3. However, keep in mind that this material participation only applies to the rental income from the building your practice operates in. If you have a condo in Hawaii that you rent out you’re out of luck and the NII tax still applies (unless of course you’re also a real estate professional who spends 500 hours each year managing rental properties – and no, lying on the beach does not count).4
Selling the Practice, Keeping the Building
That 500-hour limit can become difficult to reach for those clients who are thinking about retiring, scaling back hours, or selling the practice altogether. If your adjusted gross income during retirement is under the $250,0001 threshold then you don’t have anything to worry about because the tax won’t apply to you. However, keep in mind that although social security and retirement distributions generally are not subject to the NII tax, they still count towards your adjusted gross income and can tip the scales on your income that is subject to the tax such as your rental income.
Using the Kiddie Tax to Your Advantage
One thing that Congress did not take into consideration when it released the NII tax was the so-called “Kiddie Tax” on children with unearned income. The short and sweet version of the Kiddie Tax is any child has “unearned” income like the passive income we’ve discussed so far greater than $1,900 during a year, then that income is taxed at the parent’s highest marginal tax rate. That prevents the parent from shifting income to the child to take advantage of our system’s graduated tax rates, but there is no provision for the NII tax. In other words, if you want to avoid having all of your passive rental income from being subject to the NII tax, you could put your child in as a member of the LLC that owns the rental property.
If you are a business owner who also owns your building and you charge yourself rent, check your form 8960 or ask your CPA if that income has been properly backed out. Remember the big exceptions to the rule:
- Normal exclusions – alimony, retirement income, etc.
- Self-rented income to an active trade or business
- Kiddie tax loophole
As always, your specific facts and circumstances make a big difference, so make sure you’re using a certified tax advisor when you plan.
1 - The threshold is $250,000 if you’re married filing a joint return, $200,000 if you’re single, and $125,000 if you’re married filing separately. Yes, this is another great example of what is commonly referred to the “marriage penalty” in the tax code.
2 - Adjusted gross income is at the bottom of page 1 or the top of page 2 of your form 1040. If you have any foreign earned income excluded under section 911 such as income from PFICs, CFCs, or the rest of the foreign tax alphabet soup, then it gets added back for purposes of calculating the NII tax.
3 - See Treasury Reg. §1.469-2(f)(6) and also the final regulations issued by the IRS in late 2013 http://federalregister.gov/a/2013-28410.
4 - See IRC §469(h) and the regulations thereunder
IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any links or attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.